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Algorithmic trading has the potential to replace human traders completely, according to one of the scientists who pioneered the use of advanced trading systems in the financial markets.

If you replace humans with machinery, then costs will disappear

David Cliff, Hewlett-Packard Labs

Speaking at last week’s Financial News Trading for Investors conference in London, David Cliff, head of complex adaptive systems research at Hewlett-Packard Labs, said: “I don’t see why everything a trader does can’t be done by a machine. I don’t want to say when it will happen as the technology is not there yet.”

Algorithmic programmes are the next generation of electronic trading systems, and can process orders much faster than legacy technology or human traders. They are designed to automate complex strategies that involve slicing up orders and feeding them anonymously into the market.

Cliff, who invented an algorithmic trading model in 1996, said: “70%, 80%, even 90% of the costs on the trading floor are human costs. If you can replace those humans with machinery, then those costs will disappear. The question then is whether it is technologically feasible to do so, but obviously there are also social and political factors as well.”

Carl James, global head of equities and derivatives trading at Henderson Global Investors, the asset management company, agreed: “It should be accepted that humans will probably be replaced. Algorithms aren’t quite mature enough but you can see where they’re going.”

As volatility in the markets decreased, firms looked to algorithmic trading for cost cutting, improved efficiency and to boost their flagging margins. Since the 1980s electronic trading has risen dramatically, driven by advances in technology and the fall in system costs. Users have become more aware of the costs of trading, and markets – such as the London Stock Exchange following the Big Bang – have embraced automation.

But Stavros Siokis, managing director and head of alternative execution sales in Europe for Citigroup Global Markets, disagreed that humans would disappear from the trading process. “Algorithms are there to help traders rather than to replace them. They provide tools to aid execution and help traders achieve their ends. Transparency and simplicity is the key,” he said.

There could be no system to match and react to the information going on in a trader’s head: “No system can process news, such as the president has been assassinated, or whatever, and respond to the reaction in the market. In the next 10 years, traders will not be replaced,” he said.

Cliff, who researched algorithms for traders in open-outcry markets and market mechanisms, said algorithms are only at the start of their evolutionary curve. “Traders are animals, in the scientific sense. They are the product of billions of years of evolution. The markets have been evolving since Roman times. In the scheme of things, it is a minuscule time that computers have been around.”

Algorithmic trading developed from simple automated program trading, which could slice an order and send it at regular intervals into the market. The advances in technology, coupled with traders programming more complex strategies, gave rise to rule-based trading. This technique led to algorithms, which can automate the trading cycle in a more flexible way.

Algorithmic trading is a concept that has been embraced by the investment banks and some, such as Credit Suisse First Boston and UBS, not only develop the software but offer the use of it to their clients. Fund managers have been reticent to invest heavily in what some have called just the latest technology fad, but this is set to change.

TowerGroup, a US market research firm, said algorithms accounted for about 7% of buyside trades in the US in 2003. Henderson’s Carl James said he would allocate between 5% and 7% to algorithmic trading. But TowerGroup forecasts that the figure will rise to 21% by 2006. The consultancy said the new-found popularity of algorithms was being driven by changing market structure and a general move to electronic trading. In the consultancy’s report, Gavin Little-Gill said: “Fragmentation of liquidity and lower commission price points are driving the buyside to use algorithms.”

At the moment, the only things standing in the way of more electronic trading are the traders themselves, according to Cliff. “If you are a human trader and you put fewer than 50% of trades through a machine then you can still justify your existence to your employers. But the minute you hit 50.1% the machine is doing your job for you. So I think there is a social barrier there to more trades going through the systems,” he said.

He added that the increased use of algorithms was being blocked by the cartel mentality of traders. “The thing about cartels is that, while they seem strong and united, they’re vulnerable. It only takes one operator to set themselves up to break the cartel for it to crumble. Most of those in the industry are aware of these issues; they just don’t talk about them,” he said.

Tracy Black, an executive director at UBS, working with the European sales, trading and electronic execution teams, said human traders add more value than algorithms.

This is because algorithms are used to automate the plain vanilla trades, freeing up traders to concentrate on extracting value from more complex products. “About 30% of our volume goes through algorithms, which represents 20% of the value. Human traders account for about 30% of the volume, but the value they create is much more than that.”